Aspen Holdings has been one of the darlings of the JSE over the past five years, with phenomenal momentum taking the share price to new highs every year. Judging by the group’s latest interim results, the ride is by no means over yet.

Aspen supplies branded and generic pharmaceuticals in more than 150 countries across the world, and operates 23 manufacturing plants on 6 continents. It is a true heavyweight on the JSE, being the largest locally listed pharmaceutical company, Africa’s largest pharmaceutical manufacturer, and the ninth largest generic medicine provider in the world as of June 2013. Aspen further benefits from a strategic partnership with the global pharmaceutical giant GlaxoSmithKline, from which it acquired four branded products in 2008 in order to enter the global market.

Latest Financial Results

Aspen recently released its interim results for the six months ended 31 December 2013, and it was clear that its non-SA operations were the primary drivers behind a promising 6 months. Revenue increased by 33% to R 12bn, operating profit rose by 16% to R 2.9bn and normalised headline earnings per share jumped 23% to 467 cents compared to the previous reporting period. Cash generated from operations amounted to R 2.2bn, which is a 9% increase on a gross basis, but reduces to an 11% decrease after finance costs and tax.

The graphs above provide a breakdown of Aspen’s gross revenue and earnings by region. The proportion of revenue and earnings derived from outside SA has increased remarkably since 2011 due to Aspen’s aggressive offshore expansion strategy.

The group’s EBITA (Earnings before interest, tax and amortisation) margin has been at 27% consistently over the past 3 years, but this figure has dropped to 25% for this reporting period. Currency depreciation has caused Aspen’s SA and Asian Pacific operations to struggle, but this was partly offset by the good performance of the other international regions. The group’s margin in SA is under severe pressure due to price regulation, and the company has not been able to respond with increased volumes or enhanced productivity.

MAT = Moving Average Total

Aspen has a 16.5% value share of SA’s private pharmaceutical market, and specifically a 31% share of the fast-growing generic sector. Aspen’s market position in SA is illustrated in the graph below, and with these comparisons it is not often that the heaviest balloon also flies the highest!

Despite being the largest company by market capitalisation (size of balloon) and already having the largest value share (x-axis), Aspen was still able to outgrow its competitors.

Current Valuation and Prospects

Aspen’s share price has enjoyed a strong run over the past 12 months, with an increase of 48% compared to the ALSI’s 16% excluding dividends. The share trades at a PE of 33, which is nearly twice that of the market’s 16.8. Although strongly cash-generative, Aspen has not historically paid high dividends, and the DY of 0.6% is only a fraction of the ALSI’s 3.2%.

The global healthcare sector has had very strong defensive and non-cyclical attributes historically, and an ageing global population is expected to provide a welcome tailwind going forward. Aspen’s global exposure positions it well to take full advantage of this going forward, and provides a useful rand hedge to SA-based investors.

Aspen is held in the Seed Equity Fund at a weight of 5.0%, and is one of the top holdings of the momentum strategy.

Seed Weekly - Loss Aversion: Why it’s Rational

Standard economic theory suggests that a rational investor will feel an equal amount of pleasure for every 1 unit of gain on an investment portfolio as they would pain for every 1 unit of loss. Research has shown, however, that losses are psychologically twice as powerful as gains, with the first proponents of this behavioural trait being Messrs Tversky and Kahneman.

Chart 1 below illustrates the emotions that one should feel in theory (in black) versus the observed emotions (blue) of investors making losses and gains.

Chart 1: Pleasure vs Pain

Should one treat losses the same as gains?

I would argue that loss aversion occurring naturally is actually rational behaviour in the case of investing.

It all comes down to the mathematics involved in recouping losses – investors require more than 1% in gains for every 1% lost in order to get back to the original (breakeven) position. This also helps to explain why most successful investors place a heavy premium on avoiding permanent capital destruction. There isn’t much difference for the first 10% – 20% of losses, but thereafter the difference between the loss made and the gains required increases exponentially. Chart 2 below graphs the required gains for each increment of loss on an investment portfolio.

Chart 2: Loss v Required Gains

The required gain illustrated in Chart 2 more closely mirrors the emotions of the pain felt in Chart 1 than the theoretical position based on the assumption that gains and losses are felt equally.

At a 10% loss, you require an 11% gain to get back to your starting point, at a 20% loss the gain required increases to 25%, at 50% you need to double your return, while a 67% loss requires your investment to triple before recouping all your losses. It is evident that there isn’t too much difference up to the 20% drawdown level, but from these levels it becomes increasingly difficult to rapidly recoup your losses.

As a result of this phenomenon, Seed has designed solutions to avoid deep drawdowns as far as possible. All investors need to take an element of risk in order to ensure that your portfolios grow sufficiently to cover your retirement needs. It is important, though, to manage the amount of risk you are exposed to and mitigate portfolio risk by combining uncorrelated growth assets within your portfolio. Small drawdowns will naturally be unavoidable, but permanent destruction of capital is to be avoided at all costs.

The Seed Flexible and Seed Absolute Return Funds both combine asset classes and strategies in order to generate inflation beating returns while minimising the probability of large capital drawdowns.

Seed Weekly - Emerging Markets – Starting to Show Value?

As multi managers we are tasked with determining which asset classes are showing the most value and then finding those managers that are best placed to capitalise on the opportunities presented – thereby generating satisfactory risk adjusted returns for our clients.

Asset class, in this context, is an extremely wide term and can be defined as any asset class in any region (or grouping thereof). A few examples include, South African banking companies, global equity, European property, emerging market debt, precious metals, small cap equity, Asian technology companies, etc. As can be seen from the above, asset classes can either be very broadly (global equity) or narrowly (South African banking) defined. We typically allocate into broader asset classes, allowing the underlying manager to find the best opportunities, but there will be times when we’ll make a special allocation to a more tightly defined asset class where we see a special opportunity.

Making these kinds of decisions requires a fair amount of research into the relative performance and valuations of the various asset classes, how the returns are correlated with other asset classes in our Funds, prospects for the asset class, whether there are any managers that have shown a proven ability in the specific asset class, etc.

Over the past few years, for instance, our global equity allocation has been allocated purely to high quality, globally branded companies that have delivered excellent – market beating – returns. While the returns have been great, we understand that all good things come to an end, and valuations of these companies are not as attractive as they were in 2011. We are currently in the process of reducing our allocation to high quality companies in favour of more a more cyclical allocation. Also on the radar is whether to move a portion into Emerging Market (EM) equities.

The chart below shows the relative performance of Developed Market (DM) and EM equities since the inception of the EM index (both in US$). The line going up represents EM outperformance and the line heading down represents DM outperformance.

Emerging Market equities have outperformed Developed Markets by 3.6% per annum over this period, but have been underperforming since October 2010. The underperformance has been a combination of high starting relative valuations (in local currency) being de-rated to more normal levels and the vast majority of EM currencies weakening against the US$ over the past 3 years or so. There naturally is risk that Emerging Markets can continue to underperform over the next couple years, but the entry point is getting more attractive both on a currency and a valuation viewpoint.

We are busy with the process of identifying a suitable EM manager and determining when the correct entry point will be, so that when the time is right we are ready to invest!

Seed Weekly - Value Investing the Buffett Way (Part 5 1998 – 2002)

The period 1998 to 2002 was an exceptionally interesting five years including the Dotcom bubble, its subsequent bursting and a small market dip following 9/11. After outperforming the S&P500 consecutively for 18 years, Berkshire underperformed in 1999.

During the bubble, Warren Buffett was heavily criticised for his underperformance. Unperturbed by media critics, he stuck to his convictions and stayed out of tech companies. Although he shared the general view that society would be transformed by the tech industry’s products and services, he could not gain insights as to which participants possessed a truly durable competitive advantage. The valuations were outrageous and the companies simply brought nothing to the table when it came to patents, manufacturing processes, or geological prospects. Warren Buffett remained true to his philosophy to only invest into companies that he understood.

At the height of the Dotcom bubble, Berkshire had the worst absolute performance of Mr Buffett’s tenure and, compared to the S&P500, the worst relative performance as well. “It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.”

In retrospect, the coincidence is that the Dotcom bubble peaked on 10 March 2000 when the NASDAQ hit its all-time high whilst Berkshire shares traded at their lowest price since mid-1997. As markets fell, Berkshire made substantial purchases (being greedy when others are fearful). As one can expect, performance quickly picked up again.

One can learn a lot from Mr Buffett’s unaffected behaviour towards market sensationalists. Unless substantially large, they don’t comment on any specific investment actions they make for a perfectly good reason. “Our never-comment-even-if-untrue policy in regard to investments may disappoint “piggy backers” but will benefit owners: Your Berkshire shares would be worth less if we discussed what we are doing. Incidentally, we should warn you that media speculation about our investment moves continues in most cases to be incorrect. People who rely on such commentary do so at their own peril.”

Warren Buffett seems to be the perfect head for his company. His interests are completely aligned with those of his shareholders whilst he constantly reassures investors that he would keep at least 99% of his net worth in Berkshire Hathaway. His view on being a CEO is also quite interesting:1. Eliminate all ritualistic and non-productive activities that normally go with the job of CEO. Our managers are totally in charge of their personal schedules.
2. Give each a simple mission: Just run your business as if:
a. you own 100% of it;
b. It is the only asset in the world that you and your family have or will ever have;
c. You can’t sell or merge it for at least a century. As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations.

During 2002 Berkshire experienced a banner year, outperforming the S&P 500 by nearly 20%. It was in this years’ newsletter that Warren Buffett gave this next piece of advice to his investors:
1. Beware of companies displaying weak accounting.There is seldom just one cockroach in the kitchen.
2. Unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.
3. Be suspicious of companies that trumpet earnings projections and growth expectations.

It is these fundamentals that successfully carried Berkshire through the Dotcom bubble. They stayed invested for the long term in well managed businesses, irrespective of the short term bumps, and focussed on their overall results. Berkshire recently released their latest annual report – which is well worth the read for any aspiring investor.

Seed Weekly - Retirement Annuities

Every February I write an article about why people should use Retirement Annuities as part of their investment portfolio, but if I could get R 1 000 for every time a client, family member, friend, or acquaintance has told me that “Retirement Annuities are a waste of money”, I would be retired now and not writing this article. I have heard many stories about Mr X or Mrs Y, whose retirement annuities were inadequate to fund their retirement despite the fact that they had been contributing to them for many years.

Unfortunately many people use these stories as an excuse not to make any retirement provisions at all.

What are the main reasons for Retirement Annuities not giving sufficient Retirement Capital:

• The first and most obvious reason is that people do not put away enough money each month. If you worked for a big corporate, the total of your contributions and the employer’s contribution to retirement is often in excess of 15%. This means that somebody earning R 10 000 pm has a monthly retirement contribution in excess of R 1 500. As his salary increases, his retirement contributions also increase. People working for themselves, or for smaller companies, rarely spend this much on their retirement annuities. The problem is exacerbated when people have “traditional retirement annuities” which have life cover and other risk benefits attached to them. These risk costs radically reduce amounts available to the retirement fund.

• The second problem is the length of time people invest for. It is not uncommon for people to only start saving when they are 40 and then want to retire when they are 55. This does not leave much time for the wonder of compound interest to weave its magic.

The above problems are best illustrated by the following example. We have a client who started saving for his retirement 30 years ago into two policies – one of R 116 pm and the other R 35 pm. At that time, the contributions were probably close to 15% of his taxable income. The premiums remained unchanged until December 2007 when the client increased the R 35 pm policy to R 2 500 pm and has increased it by 10% pa since then. The total premiums paid on the R 116 policy to date are R 42 224, while the fund value is a staggering R 702 114. This equates to a return of 14.2% pa. The other policy has total premiums paid to date of R 295 516 but, because the real effects of compound interest are yet to kick in on the increased contributions, the fund value is R 574 706. This still equates to a return of 12.98% pa. It must be borne in mind that the huge tax advantages (up to 45% at one stage) have not been taken into account.

One of the major drawbacks of the “traditional” retirement annuity is the fact that it is costed upfront, i.e. your first number of premiums go towards the payment of costs and you only start increasing your retirement value after a while. Now days we have many products available where no upfront fees are accrued and very low ongoing fees are paid.

One of the major advantages of Retirement Annuities that people tend to forget is that your tax rate is usually higher pre-retirement than post retirement. Remember that post retirement you usually have lower income, higher rebates (after 65) and all medical expenses are allowed as a deduction (after 65). So the tax savings generated by the contributions are higher than the future liability created.

Do I think retirement annuities are the alpha and omega of retirement planning? Definitely not. You also need property, equities and offshore exposure in discretionary savings products, but retirement annuities definitely have their place and are ignored at your peril.

Seed Weekly - SA budget and implications for investors

Last week, Pravin Gordhan presented his 5th budget speech as Minister of Finance. The aim of the budget is to present the forecasted government revenue and expenses. The sheer scale of the government finances as a percentage of the size of the economy means that it is an extremely important consideration for all investors in the local economy.

Most governments, including South Africa, run their finances at a deficit instead of a surplus. Again the deficit in absolute terms as measured against the size of the economy is an important number because it means that the government has to find this shortfall from funds outside of the revenue that it derives from the tax base. This shortfall is made up by government borrowing from local and international lenders.

The table below presents the key components of the last years and this year’s budgets against the 2014 actual. Firstly the size of the SA economy as measured by GDP, is around R3,5 trillion. In real terms it grew by just 1,9% in 2013. This is down from growth of 2,5% in 2012 and 3,6% in 2011.

The government is however pencilling in real economic growth of 2,7% for 2014, 3,2% in 2015 and 3,5% in 2016. Because an important measurement of government finances is the deficit as a percentage of the total GDP, a higher economic growth estimate helps to lower the budget deficit in percentage terms.

For the 2013/2014 financial year the budget deficit will come in at approximately R140 billion or 4% of GDP. The forecast for the 2014/2015 year is for the deficit to increase to R153 billion, but because GDP is expected to grow slightly, to remain at the 4% level. However cumulatively borrowings increase as the government needs to borrow these additional funds in order to make good this annual shortfall. The borrowing requirement also has to take into account maturity of older debt.

For the year ahead, while the budget is to spend R153 billion more than is received, because of redemptions, government has planned net financing requirement of R180 billion for the year ahead. This is new debt added onto existing debt and this is how the total gross public debt is now expected to rise to around 45% of GDP – see chart below.

Fortunately SA has a low percentage of foreign denominated debt. However gross debt in absolute terms has increased from around R600 billion in 2009 to the current level around R2 trillion. Increased debt means increased interest costs and while the current cost of debt financing to total expenditure is 9,2%, in absolute terms it is expected to increase by 11,2% and 15,2% over the following 2 years.

South Africa has done well in the past to reign in the relative size of its debt in the past, but on the projections over the next few years, there is concern as the debt levels approach 50% of GDP.

Government finances and their debt issuance have a direct bearing on the local bond market and the direction of longer term interests rates. At the same time a growing government increasingly crowds out the private sector as the higher demand for tax revenue is a cost for both individuals and companies.